MASTER CLASS – Interest Cover as a company financial ratio measure – what it is, how to calculate why it matters Pt 2

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Financial Ratios

What is it: INTEREST COVER

The interest cover ratio, (also known as interest cover or times interest earned) is a measure of how well a company can meet its interest-payment obligations.

Working example:

The interest cover ratio formula is:
Interest Cover

= (Earnings/Profit Before Interest and Taxes) / (Interest Expense)

Eg Here is some information about XYZ Company:
Net Income/Profit          $350,000
Interest Expense         ($400,000)
Taxes                            ($50,000)
Using the formula and the information above, we can calculate that XYZ’s interest cover ratio is:
($350,000 + $400,000 + $50,000)/$400,000 = 2.0
This means that XYZ Company is able to meet its interest payments two times over.

What it Means:

An interest cover of 2 or more is considered comfortable. Usually, a high cover ratio may suggest a company is “too safe” and is neglecting opportunities to magnify earnings through leverage. An interest cover ratio below 1.0 indicates that a company is not able to meet its interest obligations.
Because a company’s failure to meet interest payments usually results in default, the interest cover ratio is of particular interest to lenders and acts as a measure of a margin of safety. However, because the interest cover ratio is based on current earnings and current expenses, it primarily focuses a company’s short-term ability to meet interest obligations.
Some industries tend to have higher interest cover ratios than others, and cyclical companies in particular can experience significant swings in their interest cover ratios (especially during recessions). As such, comparison of interest cover ratios is generally most meaningful among companies within the same industry, and the definition of a “high” or “low” ratio should be made in this context.

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